Funds and Allies Defend the Buck

Let’s start a bank. It will take deposits, promising to pay them back on demand. It will use the money to make short-term loans to borrowers it thinks are safe. If too many depositors want their money back quickly, it will sell the loans to somebody else, for face value.

Our bank will not keep reserves on hand to deal with what would happen if any of our borrowers failed to repay their loans. Keeping such reserves, you see, would be far too costly, and reduce the rates we could pay to our depositors.

Nor would we be willing to tell our depositors that they might not have instant access to their funds. That might scare the depositors away. We won’t pay fees for deposit insurance, but we hope our customers will assume that the government will protect them anyway if we fail.

That whole idea sounds crazy, but in fact we already have such banks. They are called money market funds, and they have $2.5 trillion in assets.

Mary Schapiro, the chairwoman of the Securities and Exchange Commission, is trying to impose some regulations to treat such funds a little more like banks, but that is being fought bitterly by the fund companies and by the U.S. Chamber of Commerce, which has established a Web site and blanketed the Washington subway station nearest the S.E.C. offices with ads denouncing such rules as outrageous.

The S.E.C. is expected to seek comment soon on possible new rules, but it is far from clear that Ms. Schapiro can prevail. Three of the other four commissioners have voiced sympathy for the money market fund industry. She would need at least three votes, including her own, to pass a rule. If the S.E.C. does act, there will be efforts to get Congress or the courts to overrule it.

The very existence of the money market fund industry is a tribute to foolish regulation decades ago, when banks were prohibited from offering competitive rates on savings accounts. Now, with rates very low, it is almost impossible to make money running a money market fund, but the fund groups want to stay in the business because they do not want to lose customers to real banks or to other mutual fund companies.

Currently, money market funds — unlike all other mutual funds — try to appear to be risk-free. The funds have net asset values per share of exactly $1, and “breaking the buck” is widely feared. The S.E.C. rules allow the funds to maintain that dollar value so long as the real value is at least 99.5 cents.

But of course the reality is that money market funds do sometimes lose money on securities they buy. The buck is broken far more often than fund investors realize — or it would be if fund sponsors did not step up and take the losses themselves. In Senate testimony this month, Ms. Schapiro said the commission had counted 300 cases in which the fund sponsors bailed out their funds over the years.

In 2008, the sponsor of the Reserve Primary Fund, which owned Lehman Brothers securities, could not afford to do that. The fund broke the buck and caused a run on all money market funds, even ones that invested only in Treasury securities. The government stepped in to guarantee all money market funds.

“Unless money market fund regulation is reformed,” Ms. Schapiro testified, “taxpayers and markets will continue to be at risk that a money market fund can break the buck and transform a moderate financial shock into a destabilizing run. In such a scenario, policy makers would again be left with two unacceptable choices: a bailout or a crisis.”

Photo

Mary Schapiro of the Securities and Exchange Commission at a House hearing this month.Credit
Saul Loeb/Agence France-Presse — Getty Images

Implicitly, the fund industry wants us to assume that the government would choose the former.

Ms. Schapiro has suggested a few possibilities. One would be to adopt variable pricing of fund shares, so that if the real value was 99.51 cents, that is what you would get from redeeming the shares. As it is, she pointed out, a fast-moving institutional investor that senses trouble can shift the losses onto other investors. If a fund’s real net asset value is 99.74 cents, and large investors redeem half the shares for $1, the net asset value of the remaining shares will fall below 99.5 cents.

To the industry, variable pricing is anathema. The institutional investors that treat money market fund shares as cash would be forced to change accounting systems, at great expense. Retail investors would flee once they realized that losses were possible.

Another approach, she testified, would be to force the funds to hold reserves against such a loss. So the real net asset value of a fund listed at $1 would have to be a little higher than that, with the sponsor putting in the extra money either from its own funds or through reducing the payouts to customers. In that case, a fleeing investor, taking the $1 per share, would be strengthening the fund for the remaining customers.

Or funds could be required to put restrictions on large withdrawals, making it harder for a well-informed investor to get out when trouble comes and leave the losses to the others.

Any such rules, protests the U.S. Chamber of Commerce Web site, “would fundamentally change the quality and characteristics of money market funds,” causing both individual and corporate investors to flee.

It says that if regulators can prove changes are needed, “they should find solutions that preserve the versatility and usefulness of the product for businesses to avoid needlessly hampering our economic recovery.”

In other words, don’t do anything to stop the industry from continuing reserve-free banking — banking that benefits from the assumption that the government will again step in to avoid a crisis.

The chamber has other worries. It fears that the commercial paper market, which provides loans to companies for weeks or months, would be damaged by the decline of the fund industry. “Since money market funds purchase one-third of all corporate commercial paper, a shrinking money market fund industry would reduce the market for this vital type of financing,” it states, adding that “bank lending does not have the capacity to replace the entire void that would be left by a defunct $1.1 trillion commercial paper market.”

As it happens, relatively little of that money is going to such companies anyway. The latest figures show just under $1 trillion in commercial paper outstanding, of which 21 percent is used to finance nonfinancial domestic businesses. Much of the rest goes to foreign banks.

So-called prime money market funds, which seek relatively high yields, “have evolved into a critical source of short-term wholesale funding for large global banks,” said David S. Scharfstein, a finance professor at Harvard Business School. “They are now a much less important funding source for nonfinancial firms.”

If investors did pull money from money market funds, much of it presumably would go into real banks, which would have more money to lend to American companies. But the chamber warns that instead, the money could flow into “offshore investment vehicles or other unregulated investment products,” thus increasing the risk to the system. Do they really think that people — confronted with the reality that there were small risks in money market funds — would move the money to funds that obviously had much larger risks?

In 2010, the S.E.C. imposed rules that force funds to carry 10 percent of their assets in Treasuries or securities that can be redeemed each day, and another 20 percent in assets that mature within a week. It also gives funds the ability to immediately halt redemptions in the event of a run, an action that would destroy a fund but would at least treat all shareholders alike. Those changes mean funds will be better equipped to deal with withdrawals, but they do nothing to protect investors in a 2008-like crisis. That is the goal of the changes Ms. Schapiro hopes to adopt now.

It is widely expected that Ms. Schapiro will step down after the election, regardless of whether President Obama is re-elected. This could be her last major accomplishment. Or it could provide evidence that we have short memories, and the financial lobbies that want bailouts without real regulation have regained the power they had before the credit crisis erupted.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

A version of this article appears in print on June 29, 2012, on page B1 of the New York edition with the headline: Funds And Allies Defend The Buck. Order Reprints|Today's Paper|Subscribe